Reinventing finance

August 24th, 2009

The financial crisis that reached its height in September-October 2008 has presented a once-in-a-lifetime opportunity to reinvent finance, ensuring it exists to serve business and society, rather than the other way around. Yet the agenda of free-market politicians and finance industry insiders is to pretend what happened was a ‘blip’ and to seek a return to business as usual. We must not allow them to close the waters on this debate.

One might have thought that the events of last October, in which scores of banks collapsed around the world and ended up having to be bailed-out by governments, would have proved that the strain of unfettered free-market capitalism unleashed by Ronald Reagan and Margaret Thatcher in the 1980s had failed.

Speaking last autumn the Nobel prize-winning economist Professor Joseph Stiglitz put it succinctly: “The fall of Wall Street is for market fundamentalism what the fall of the Berlin Wall was for Communism — it tells us that this way of economic organisation has turned out to be unsustainable. We now know the model doesn’t work … that the claims of financial market liberalisation were bogus.”

For a few short weeks last autumn it seemed the crisis would bring real change. The failings of unfettered free market capitalism had been laid bare, presenting an unprecedented opportunity to re-evaluate what our economy is actually for and reinvent capitalism for the better.

The political rhetoric that accompanied the bail-outs was all about cracking down on irresponsible bankers, smarter regulation, reining in bonuses, economic reform, etc. But ,10 months, on such talk has all but evaporated. The prime Minister, Gordon Brown, and chancellor Alistair Darling have singularly failed to grasp the opportunities the crisis presented.

Their ears bent by their friends in the City of London, they have let themselves be convinced that, despite the £1.3 trillion of public money that has been thrown at the banks, these institutions should be allowed to pick up where they left off as though nothing has changed. They have also created a bonanza for investment bankers and risked sparking hyper-inflation with their £175 billion quantitative easing programme.

Brown and Darling hope their munificence will enable the clearing banks to start spewing out credit once more, so that the debt-fuelled party and house price boom we were all so enjoying (not) before the crisis might be recommenced … just in time for next year’s general election.

But we must not allow guilty bankers to walk away from a car crash of their own making without at least relearning their driving skills, doing some community service or perhaps even spending some time in the clink.

As Philip Augar, author of The Death of Gentlemanly Capitalism, The Greed Merchants and Chasing Alpha said last week at the Edinburgh International Book Festival, “We must not allow finance industry insiders and free-market politicians to close the waters on the debate”. And as the esteemed FT economics commentator Martin Wolf recently pointed out: “The idea that we can all go back to business as usual now that government has saved the situation is insane.”

Rather than focus our disgust on bankers’ greed and specifically their bonuses — that’s becoming a bit of a stuck record, I fear — we should be focusing on the wider debate.

We should be urging regulators, bankers and politicians to take a more sustainable view of the future of banking and the financial system. This is going to be much, much harder than simply striving to wind the clock back to the discredited models of the past; it’s going to mean policymakers actually having to use their imaginations rather than just being the bankers’ puppets. But it’s definitely still possible.

Sargon Nissan, a former hedge fund manager who is now a researcher at the New Economics Foundation, recently said [writing in the magazine Red Pepper]: “Civil society efforts against financial liberalisation internationally must now find common cause with the grass-roots movement of local investment and financial alternatives on their doorstep and together capture the collective imagination….”

I’d now like to look at some of the practical ways in which this might be achieved.

First, we need to find ways of making the existing financial players -– with the focus on shareholder-owned, stock-market listed banks and other consumer-focused financial institutions — more accountable, more responsible, more answerable to their customers and more answerable to society at large. This will require much more than the half-hearted regulatory tinkering we’ve seen so far from Brown and Darling.

To have a chance of success we’re going to need:-

1. Better regulation, a revised Basel accord, higher capital ratios that are more commensurate with the risks being taken and the transfer of all derivatives trading onto regulated exchanges.

2. Independent credit ratings agencies with a saner funding model.

3. Greater transparency within the banks -– including more detail of who they’re lending money to.

4. More honest accounting. This will necessitate a break up of the ‘big four’ audit firms — PricewaterhouseCoopers, Deloitte, KPMG and Ernst & Young — which are too conflicted and too cosy with their banking clients to be capable of producing independent audits. We should consider introducing a publicly-funded independent auditor for the banks, as proposed by Prem Sikka, professor of accountancy at Essex University.

5. Corporate governance to be completely overhauled, ensuring those at the top of institutions know what they’re doing, and that non-executives are genuinely independent and no longer selected because of their membership of a self-serving and blinkered elite. We should ensure the people running large institutions have “domain knowledge” — craft skills pertinent to their area of business — as advocated by Kenneth Hopper and William Hopper in The Puritan Gift: Reclaiming the American Dream Amidst Global Financial Chaos. We also find ways of ensuring the people at the top of banks are motivated by something other than just personal greed.

6. Rather than focus on reining in bonuses, which are a symptom of excessive profits, we need to tackle their cause — the excessive profits themselves. Why is it that banks routinely make excessive profits? Is it because the City became bloated and arrogant as a result of over-simplistic deregulation in the 1980s and 1990s? Do conflicts of interest lead mainstream financial players to routinely put their own interests ahead of those of their customers? Have the rest of us, including non-financial companies, simply been too naïve, too gullible, too content to have rings run around us?

7. To persuade investors, especially institutional investors, to take a longer-term view of the companies in which they invest. I have some sympathy with Lord Myners’s recent suggestion that longer-term investors should be rewarded for their loyalty with enhanced voting rights -– as already happens in continental Europe.

8. To persuade investors to focus on the “triple bottom line” — profit, people and planet — rather than profits alone. The Norwegian government pension fund is showing what can be achieved here, and the UN’s global reporting initiative, which seeks to ensure that reporting on economic, environmental, and social performance is as mainstream as financial reporting, is also leading the way. Charities, with some £60bn of investments at their disposal in the UK alone, must start using their financial muscle to much greater effect.

9. To break down “too-big-to-fail” banks such as Lloyds Banking Group to ensure that their customers (both individuals and companies) and staff get a fairer deal. A version of the Glass-Steagal Act should be enacted to separate deposit-taking institutions from proprietary trading, the “casino” of bankers gambling with other people’s money on opaque instruments that few fully understand.

10. Financial institutions that are more rooted in their communities. The UK government and the EU have this within their gift. They could, for example, break up RBS, Lloyds/HBOS and other state-owned banks into more manageable, regionally-focused institutions. Some of these, including the former Trustee Savings Bank branch network, should be re-mutualised.

This brings me on to the second way of re-orientating financial services so they exist to serve society -– not just to line the pockets of (sometimes) their shareholders and (always) their bosses. We need to create a legislative and regulatory framework in which financial services players with different agendas and alternative ownership structures can thrive.

One reason the financial crisis was far more extreme in the UK than in almost any other country (except Ireland or Iceland) was that, since Big Bang in 1986, we have allowed a rapacious financial monoculture to become dominant here. A corollary was that the non-plc sector was allowed to wither on the vine.

We allowed our financial market to become dangerously imbalanced. This has huge consequences for the economy and society at large, as shareholder-owned banks tend to support and back organizations that think along similar lines as themselves — including buccaneering retail tycoons, amoral property developers and monochrome pub chains. Their support for these sorts of businesses has had disastrous consequences both for UK society and the built environment.

In 1980, building societies accounted for 78% of UK mortgages. The figure today is less than 20%. (Source: The Nature and Role of Building Societies, www.iut.nu). This is not just the fault of the regulatory authorities and the government; it’s also the fault of building society members who, motivated by personal greed, exchanged long-term ownership for short-term ‘windfalls’ in the late 1980s and 1990s.

In the end, given the reckless course on which former building societies including Halifax, Northern Rock and Bradford & Bingley embarked post-demutualisation, the supporters of conversion ended up shooting themselves in the foot.

My overall estimate is that alternative models (as opposed to publicly listed institutions) today account for less than 10% of the UK financial services market. The equivalent figure in most European countries is 40%-50%. Even in America, the supposed home of neo-liberal capitalism, the figure is above 30%.

It’s no coincidence that surviving mutuals like Rabobank in Holland, DZ in Germany, Nationwide in the UK, co-operative banks such as The Co-operative Bank in the UK, surviving savings banks like Airdrie Savings Bank and ethical banks like Triodos took fewer risks and behaved more responsibly during the bubble than their shareholder-owned peers.

Their motivations are different. Their ownership structures mean they’re obliged to think beyond the current quarter’s profits. So rather than putting the needs of short-termist investors on a pedestal, they can take the needs of all stakeholders — including customers, staff , the environment, society, the wider economy — into account.

These more social institutions -– widely denigrated and side-lined during the bubble years -– have now come into their own. They have been pulling in enormous sums in deposits and growing their loan books as a result of the collapse of their shareholder-owned rivals.

Put simply, people trust them more. They have demonstrated that a cautious approach to banking, based on traditional values with a strong social ethic, will in the long-term ensure they beat plc banks.

Rather than lending unethically and recklessly in pursuit of the highest short-term gain, these more social banks invest for the long term and remain close to their local communities -– where they are more willing to fund innovative start-ups and small and medium-sized enterprises than their plc counterparts. They are also far less likely to feel the need to pay obscene amounts of money to their top executives.

And it’s worth pointing out that the mutually-owned Rabobank is currently the only bank in the world to have AAA rating from Standard & Poor’s (for what that’s worth).

Cynics might say ‘what about the US Savings & Loan crisis of the 1980s?’ or ‘What about Dunfermline Building Society?’ Well, I would say, yes, recklessness can occur under any ownership structure; but I would also point out that, whereas it has cost the UK government £1.3 trillion to bail-out the publicly listed banks, it has only cost only £55 million to bail-out Dunfermline.

There’s also significant scope for ‘social business’ to step into the lending void caused by the bank crashes of 2007-08, including non-profit models of local lending such as credit unions and community development finance institutions (CDFIs) along the lines Muhammad Yunus’s Grameen Bank microfinance initiative in Bangladesh.

Professor Tony O’Rourke of Stirling University, an expert in social finance, believes that credit unions such as ScotWest in Glasgow and Capital in Edinburgh also have an important role to play, given their ability to tackle financial exclusion by offering accounts to customers who are shunned by conventional banks. He believes that credit unions ought to be able to replicate what was achieved by the savings bank movement in the 19th century.

And as you have heard, Craig Campbell, former head of community banking at HBOS, plans to establish a new “social bank” here in Scotland within the next two years. This would focus on lending to companies with a social objective. There are parallels with Govan-based DSL Business Finance, another not-for-profit “social lender”. This runs a £1.5m loan fund for small and start-up firms and returns any profits to the fund to lend to other businesses, particularly those located in disadvantaged areas.

The government should also consider establishing a contemporary version of ICFC (Industrial & Commercial Finance Corporation), which later became known as 3i, in order to provide risk capital to strategically important, riskier sectors of the economy and promote innovation. After all, the banks are currently so obsessed with rebuilding their balance sheets they’re in no mood to do that.

And the European Commission should require member states to introduce transparency measures similar to those introduced via the US Community Reinvestment Act of 1977. This could force banks to become more open and honest about whether they are denying accounts to certain types of customer (by race, gender, religion etc) and about the take up of “basic” bank accounts. (The last two ideas were originally proposed by the thinktank the Financial Inclusion Centre)

Largely thanks to the erosion of the building society movement post 1986, grassroots alternatives to mainstream financial institutions are today fairly niche in the UK. According to the New Economics Foundation, community development finance institutions account for less than £300m of lending in the UK and credit unions have only taken in £400m in savings.

In the US the community finance sector is much better developed. It accounts for billions of dollars and is much more vibrant than here. President Barack Obama recognises that it has a major role to play in rebuilding the US economy -– he channeled $100 million into the sector in last year’s stimulus package.

By contrast, Gordon Brown and Alistair Darling prefer to focus on quick fixes. Their game plan is to help their mates in the City of London and resuscitate the Frankenstein’s monster that was early 21st century finance. Rather than seek biodiversity in financial services, the Downing Street duo want a return to the rapacious monoculture that got us into this so much trouble in the first place.

We must not allow them to get away with this.

Nor must not neglect the window of opportunity which, despite everything, remains ajar. There has never been a better time to force existing financial services players to become more accountable, transparent, responsible and sustainable -– and to counterbalance their power by promoting the development of a more vibrant alternatives/non-quoted sector.

Surely these represent better ways to build a more stable and more equitable financial system that our children could be proud of than blindly seeking a return to the utterly discredited status quo ante?

A very good summary and set of proposals. People like Joseph Stiglitz and Prem Sikka are 20 years ahead of their time. Even if a tiny fraction of their ideas were acted on, it would save a lot of pain.

I really enjoyed reading ‘reinventing finance’ and would like to invite you to speak at the Chartered Institute of Marketing on your perspective relating to banks being more answerable to the customer and society at large.
Kathy Lewis
Chair of the Finance Group
Chartered Institute of Marketing

[…] Reinventing finance British Journalist Ian Fraser spoke passionately in Oct. 2009 about the need for financial reform and why it is vital that governments in the UK, US and Europe not resort to the quick fix. […]